A respected client of the Agency Consulting Group has recently analyzed the impact of direct bill income on the working capital and asset base of their independent agency.
They found it difficult to maintain a “healthy” 30 day working capital requirement to satisfy financial institutions because of a conversion of much of its premium base from agency bill to direct bill.
The agency calls their accounting system a “hybrid” for the reporting of commission income. Agency billed items were recognized as revenue as booked into their system “based on the effective or invoice dates” while direct billed items are recognized as revenue when the cash is received (based on the direct bill statements). We have found that this procedure is quite common in insurance agencies through out the United States because of the difficulty and complexity of recognizing direct bill income (primarily on personal lines) as policies renew. For the most part, while policy information is updated on direct bill personal lines policies, premiums (and commissions) are recognized as a bulk entry in the general ledger when the commission statements are received. The agents have found that it is simply too difficult to justify personal lines direct bill policies on a item by item basis.
In recent years a substantial amount of commercial lines have also been converted to direct bill for a variety of reasons. Some agents continue to post each individual policy as received, and justify commissions when the appropriate commission statements are received by the agency. This item remains a receivable until the premium is paid to the company by the customer. Other agents have begun treating small commercial lines like personal lines and only recognizing the commission as it is received on the commission statements.
The problem occurs because commissions registered when the policies are booked are considered assets and become receivables and payables to the company. They are considered income to the agency immediately. Direct bill commissions, that are not recognized until the cash is received on the commission statement, on the other hand, are not recognized as revenues until the cash receipts are posted. In reality, policies are issued and are in effect, and in an accrual based system, this revenue would be considered as agency revenue when the policies are posted. While this delay is only temporary, it hides an asset of the agency-namely the direct bill commissions accrued to the benefit of the agency prior to the date that the cash is received.
Typically this is of little concern to the active on going agency. However, when an agency direct bill commission exceeds 50% or 60% through the conversion of commercial lines policy to direct bill, two impacts are noted as a result of this hidden asset. First, greater pressure exists on working capital. Less cash is available and less revenue is posted into the general ledger even though that revenue is assured of arriving. Second, a question exists regarding the impact of the hidden asset on the value of the insurance agency. Since the asset is unreported but guaranteed to arrive within a short period of time, should that asset be posted as an enhancement to the value of the agency?
Our answer to our clients question was not necessarily. The reason that this asset may not effect the going concern value of the agency is that revenue that would have accrued to the benefit of the prior year was rolled over to the current year as a result of this practice. Much of the November direct bill policies and all of the December direct bill policies were unpaid until January. Under the current scenario those revenues were included in current year income to establish the value and growth trends of the agency. It is also expected that this years November and December policies would roll their revenue and cash flow into January and February of next year.
However one part of the valuation can be effected by this issue. In the normal value of an agency for a potential perpetuation or sale, a working capital requirement of 30 days is normal to assure the continued operation of the agency under new ownership. In the scenario described above, the hidden asset of the cash expected as a result of policies written on direct bill in the prior 30 to 45 days would act as a ready source of cash to continue operations under changed ownership (as long as that value wasn’t calculated as part of the purchase price). Under those circumstances it would be appropriate to reduce the working capital requirement, thereby increasing the value of the agency.
If you have any questions about the “hidden asset” and how it effects your agency, please call us.